CFA Institute Journal Review October 2015 Volume 45 Issue 10
What’s Growth Got to Do with It? Equity Returns and Economic Growth (Digest Summary)
Journal of Investing
Equity market returns and earnings growth rate are largely uncorrelated with economic growth across the world for all capitalization-size segments. The author expands the scope of previous research carried out for large-cap stocks to include mid-cap and small-cap stocks for developed and emerging markets.
The author studies the impact of economic growth on equity market returns and earnings growth for large-cap, mid-cap, and small-cap stocks in emerging and developed markets. He studies the correlation between (1) real return and per capita real GDP and (2) real earnings growth and per capita real GDP.
How Is This Research Useful to Practitioners?
Hardly any correlation is evident between real stock market returns and per capita real GDP for large-cap, mid-cap, and small-cap indexes for the sample of 44 developed and emerging markets. In Singapore and Hong Kong, per capita real GDP growth rate is the highest among developed economies but equity market returns are among the lowest, whereas Australia and New Zealand achieve some of the highest equity market returns but have average or below average per capita real GDP growth rates. The results of cross-country correlation between returns and per capita real GDP show negative correlation for all markets (developed, emerging, and both combined) with large-cap and mid-cap stocks. The small-cap correlation is not significantly different from zero. These results are in stark contrast to high positive correlation with such valuation measures as the price-to-earnings ratio and real equity market returns. Thus, the results suggest that the stock market returns are predominantly driven by valuations and not by economic growth.
Cross-country correlation between returns and global per capita real GDP growth is not significant. Countries dependent on exports show a higher correlation with global growth than with their local market growth when compared with larger, more domestically oriented economies, such as the United States and India. But these correlations remain small and only slightly positive.
Real earnings growth and the per capita real GDP growth, together with cross-country correlations between the two variables, are close to zero. The reason for this result is that real earnings growth can be higher even when per capita real GDP growth is low, which can happen if a country’s population grows rapidly, such as in the case of Australia, Switzerland, and the United States. But such countries as Germany and Japan had limited population growth but still enjoyed high real earnings growth in the past, which could be a reflection of the ability of enterprises in these regions to capture market share around the globe. Many emerging markets show low earnings growth despite high population growth rates.
These results do not refute the view that earnings divided by GDP are stationary in large economies like the United States because the author is focused on cross-country correlations and not correlations over time. But they do cast some doubt on whether earnings divided by GDP are stationary in small, open economies.
The author concludes that equity market returns are largely uncorrelated with economic growth across the world for all size segments. But correlations between valuation measures, such as price-to-earnings ratio and stock market returns, are high because stock market valuations incorporate future growth expectations into the price of stocks.
How Did the Author Conduct This Research?
For 22 developed and 22 emerging markets, the author investigates the equity market returns of large-cap, mid-cap, and small-cap stocks using MSCI indexes for each country. The data are from 1997 to 2013 so that at least two business cycles in each country are covered. The result is representative of a general trend. To calculate real equity market returns and per capita real GDP growth, the author uses consumer price inflation data and per capita real GDP data from the International Monetary Fund website.
He calculates the cross-country correlation between returns and global GDP per capita growth to investigate the relationship between global growth and stock market returns. Earnings growth may still be linked to the economic growth of a country despite the valuation capturing most of the anticipated growth. To check this relationship, the author calculates real earnings growth for large-cap equities and compares them with per capita real GDP.
The author’s findings show that future economic growth seems to matter little for both earnings growth and equity market returns, whereas valuations matter and remain the main driver of future stock market returns. Investors often overpay for growth by investing in overvalued stocks with exposure to fast-growing markets. It would be interesting to see the results of a comparison of returns and earnings growth using the real GDP growth rate instead of the per capita real GDP growth rate. Different population growth rates across all markets can distort the comparison with per capita real GDP growth rate.
About the Author(s)
Biharilal Deora is a director at Abakkus Asset Manager LLP, an India-focused asset management company. His investment expertise spans a broad array of asset classes. Prior to joining Abakkus, Mr. Deora was managing corporate, family office, and university clients. He began his career as a financial analyst at leading financial services firms, such as Credit Suisse and Fidelity Investments. Mr. Deora holds a master’s degree in commerce from Veer Narmad South Gujarat University.
He is a top-ranking chartered accountant and a certified financial planner. Mr. Deora serves as a director on the board of CFA Society India and is a visiting faculty member for advanced finance programs.